Tuesday, January 14, 2014

The Panacea that is Lowering Interest Rates

In a nutshell, the argument for higher inflation is simple. Right now, with interest rates at slightly above zero and inflation running a little less than 2 percent, real interest rates are about -1 percent. But that's too high. Given the weakness of the economy, the market-clearing real interest rate is probably around -3 percent. If inflation were running at 4-5 percent, that's what we'd have, and the economy would recover more quickly.

There are two arguments opposed to this. The first is that central banks have demonstrated that 2 percent inflation is sustainable. But what about 5 percent? Maybe not. If central banks are willing to let inflation get that high, markets might conclude that they'll respond with even higher inflation if political considerations demand it. Inflationary expectations will go up, the central bank will respond, and soon we'll be in an inflationary spiral, just like the 1970s.

I find it remarkable that Drum is so easily drawn into the rabbit hole of monetarism, a world where the Fed Chair reigns as the Wizard of Oz and economic weakness is solved by a willingness to let inflation get high. What conceivable logic lies behind such fantasy?

All countries have structural economic problems. In the United States, our labor force is not competitive because labor is cheaper elsewhere and the technology and political structure exists to move jobs to these other locations. That is the "economic weakness" of which Drum speaks. In spite of extremely low interest rates, the American consumer isn't earning enough money to consume more and make additional private investment profitable.

How could the solution to this be just to reduce interest rates? How would that address the structural problem in any way? We've been trying this in the U.S. for over 30 years now (see this graph). Phil Pilkington and others discuss how well this has worked:

Kalecki’s argument was that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone.
[Fixing the Economists]

In sum, a group of bizarro monetarist economists and their naive followers have captured the high, serious ground They believe that structural problems, such as offshoring and outsourcing of jobs, can be fixed by lowering interest rates. This has been tried for 30 years whenever the economy falters, and the problem is worse than ever, and rates can't go any lower. Lower interest rates have yielded lower inflation, to the extent that there is any discernable effect of monetary policy on inflation. But they believe the problem would be solved if we just somehow get interest rates into negative territory.

Central bankers seem to think that over the past 30 years they've demonstrated credibility in restraining inflation, something they're loath to give up.

I don't doubt that central bankers think this, but I do doubt that central bankers had anything to do with restraining inflation over the last 30 years. After all, they reduced interest rates over that time period which, according to their theory, should have increased inflation. Obviously, globalization, offshoring, outsourcing, and the adoption of "ownership society" laws (crushing unions) caused the disinflation, and central banks just tried to keep up by reducing interest rates.

It would seem that in a developing or emerging nation where there is a high demand for credit and there is not yet more financial assets than debt outstanding, that lowering interest rates should cause growth and inflation to accelerate. In a developed nation where more financial assets exist than demand for credit then lowering interest rates would be deflationary? The line probably gets a bit blurry in between.

Does anybody seriously thing that a developing or emerging country can direct its economy by tinkering with interest rates? Can Ghana become more serious by raising interest rates? Would it make any significant difference if China or India raised or lowered interest rates? Of course not.

Every country has real economic issues to deal with. For example, many east Asian countries have adopted mercantilist policies which have increased their competitiveness. They have manipulated the value of their currencies and promoted exports.

It seems that it's far more effective to consciously address structural economic problems as opposed to pretending that tinkering with interest rates will make an economy more competitive and/or more self sufficient...

I see your point and I generally agree. I think to attract foreign capital, and foreign currency sometimes interest rates are effective. The Ghana currency isn't going to buy a tanker of oil or a boat load of iron ore or a load of corn on the open market. But a Euro, Yen, or Dollar will. I think they should try to force every possible part of bilateral trade to occur in their own currency. Not everyone will play ball though.

Agreed. Each country should define its goals first. Then perhaps interest rate policy (aka monetary policy) can play a role in attaining the goal. For the U.S., the goal of increasing employment and working class prosperity should drive more detailed policy proposals. Keeping interest rates low might be a part of that, but the notion that low interest rates will generate some sort of "market clearing" that will resolve major problems with employment and labor is nonsense IMO...

To be perfectly crude about it, white liberals of the current generation still have Ronald Reagan's di** shoved firmly up their a**holes. They experience Ronnie-induced palpitations of fear and quaking whenever somebody starts talking about using the blasted government to just DO the things that need to be done. They were brainwashed back at the end of the 20th century into thinking that an activist state means Communism and Gulags and Bread Lines and Collapse.

And yet when the US had a big activists state in the mid-20th century, it had consistently strong growth, financial stability, socioeconomic equality and optimism. As the capitalist began attacking and undermining capable government from the 70's onward, we have had declining growth, surging inequality, bubbles and instability, a blown-up social contract, and a proliferation of consumerist addictions and cultural shallowness.

Congratulations to Detroit Dan for drawing attention to the latest bit of monetarist nonsense. I can think of three more nails to put in the monetarist coffin, not mentioned above.

1. As pointed out on this blog recently, the Fed recently produced a study showing that the relationship between interest rates and investment is tenuous.

2. The optimum rate of interest is the free market rate (unless someone can prove market failure). Fiddling with interest rates is therefor not justified any more than is fiddling with the price of steel or hamburgers.

3. Interest rate adjustments are a DISTORTIONARY: they influence just one form of economic activity, namely borrowing and investment. I.e. there is no more reason to boost investment spending in a recession than there is to boost spending on cars or restaurant meals.

Deliberately stoking inflation so as to bring about a negative real rate of interest is an absolute stroke of genius. Consider…

Let’s say inflation is 10%pa. So I make minus 10% if I leave my money in the bank. So to avoid that, I place my money with someone who invests my money and makes minus 5%. I.e. 5% of my investment is destroyed per year. E.g. my money is invested in the World Trade Centre and the top 5% of the twin towers are removed every year.

The nail in the coffin for monetarism might have to be a big deflation...

iow we have seen how manifestly lowering the IR has had little/no effect on employment, I think Bernanke's tenure may result in NO net jobs being created during his whole tenure... its going to be close

Next what we need is a big "deflation" which imo has to come from an oil price collapse, if we can get oil to collapse then everything would go down in price and would we be faced with a nice deflation and that might be it finally for monetarism...

Right now it is still hanging on by a string as we have avoided an outright price collapse but things look to be settling down in MENA and if we get some substitution and NA production gets going we could see oil price ratchet down and then the monetarists would be done once and for all hopefully...

I noticed in Mosler's presentation for Italy that he would prohibit interbank lending.

I love that approach. Economists will hate it because of their fascination with intermediation. It helps break the mindset of reserve requirements and management. It also makes regulators jobs very, very simple to regulate institutions and eliminate TBTF.

The usual assumption in economics (which I agree with) is that the free market should prevail unless someone can prove there’s a serious defect in the free market. And no one has shown that the free market produces too high or too low a rate of interest, far as I know, ergo I claim interest rates should be determined by market forces.

As to what the free market rate is (e.g. for a near risk free loan), I’ve no idea. We’d have to get rid of all interferences in the free market to find out, and that includes getting rid of some or all government borrowing. Milton Friedman and Warren Mosler advocated regimes where governments / central banks issue no interest yielding liabilities: i.e. where they incur no debt. The only liability they issue is monetary base. I quite like that idea.

"The free market" is a trope. There is no such thing as "the free market." There are market transactions. Lots of them. They are conducted jaw the laws of the jurisdiction in which they take place and according to institutional arrangements, as well as customs.

"The free market" is an invention of neoclassical economics, which is entirely idealized and non-representation.